Commentary

Squeezing wages keeps inflation bottled up

Commentary: The dark side of American productivity

WASHINGTON (MarketWatch) – American businesses are world class in one regard: squeezing costs, especially labor costs.

It’s the chief reason why the unemployment rate remains so high, and it’s the reason most people don’t expect much inflation over the next year or two, despite $100 oil.

Everyone in America knows the bitter truth: We workers are expected to pull our own weight, and then some. Anyone who can’t keep up is ruthlessly cut from the team. Job security is something we only read about in the history books. If we stumble, we’ll be trampled underfoot.

What’s more, unless we’re one of the favored few, we don’t expect a raise this year, even though we’re working harder, smarter, faster, better. Profits are up — way up — but they won’t trickle down to us.

There’s something different about the way the economy works now than it did for our parents. Once upon a time, the boss could afford to be a little generous. Maybe it wasn’t benevolence, maybe it was because workers could actually stand up and look the boss in the eye and demand their fair share of what they’d made.

Whatever, those days are gone. Today, the boss gets almost all of the benefits of greater productivity.

In 2010, the first full year of growth after the recession, U.S. output increased 3.7%, the Bureau of Labor Statistics reported Thursday. To produce all those extra goods and services, American workers put in just 0.1% more hours on the clock. Productivity increased 3.6%. Read our full coverage of the productivity report.

The load got much heavier, but it was the same old team of mules that had to pull it. Even though there were 15 or 20 million others chomping at the bit to get in the harness.

What did we get for that extra effort? Just a little extra hay: Wages rose 2%, but most of that was inflated away. After adjusting for higher prices, real compensation rose just 0.3%. If you earned $1,000 a week in 2009, you got the equivalent of $1,003 in 2010, enough for an extra doughnut at the coffee shop.

The boss got the profits, we got crumbs.

Labor costs falling

What does this have to do with inflation? Everything. Businesses’ costs are the main driver of inflation, and labor is the main cost of doing business. Due to the rapid increase in productivity in 2010 and the pathetic increase in wages, the cost of the labor needed to produce a ton of steel or a loaf of bread or a post on the Interwebs fell by an average of 1.5% in 2010 after a 1.6% drop in 2009. Read more on the BLS website.

The decline in these unit labor costs means that businesses aren’t being pressured to raise prices to maintain their profits. In fact, they can cut prices compared with a year earlier and still earn higher profits. They can even afford to give their hard-working employees an extra crumb as a reward.

Most people tend to think inflation comes from higher prices for oil or other commodities. But that’s wrong: Inflation isn’t an increase in a few prices, but rather it’s a general increase in almost all prices across the board.

An increase in just a few prices leads to adjustments in both supply and demand that create a new equilibrium, but it needn’t have any recurring effect on prices overall.

For instance, higher oil prices lead to more drilling on the one hand, but also to less driving on the other until supply and demand are equalized again and the price stabilizes.

But to get sustained inflation, almost all prices have to rise, especially wages. Paying higher wages in turn forces all businesses to raise their prices, and those higher prices stick because the workers now have the extra income they need to afford the higher prices. That’s the wage-push inflationary cycle.

Think about it this way: Every business would like to raise its prices, but most businesses are constrained by what their customers will pay. What customers will pay is constrained by how much money they have and whether they can be satisfied by buying from the guy down the street.

Businesses can’t raise prices

Income and competition put a limit on price increases. Today, most businesses face incredible competition from around the globe. For their part, consumers just don’t have the extra money to pay higher prices. Higher prices can’t stick.

Back in the 1970s, higher commodity prices did push through into higher prices for everything else. But since the 1980s, that link has been broken. Economists at Goldman Sachs have found that, during the 1970s and early 1980s, a 10% increase in crude oil prices led to a 0.25% increase in core prices (which by definition exclude food and energy prices) within a few quarters. But since then, a 10% rise in crude prices has had no significant effect on core prices at all. There’s no feed-through.

Higher commodity prices do have a real impact on our well-being. Paying more for energy or food does hurt, because everyone has to eat, and most of us have to drive or heat our homes. But higher commodity prices aren’t creating any sustained inflationary pressures in other prices.

Why don’t we have an inflation problem? Because American businesses are world class at squeezing labor costs — that is, wages. Unfortunately, the rapid increase in productivity in the American workplace is also keeping millions of willing and able people on the unemployment lines.

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